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Fair-value accounting as new GAAP? That's unacceptable!

Off the bat, say goodbye to fixed-rate loans

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By George Darling, Darling Consulting Group

Anyone who has read the 214-page Exposure Draft issued on May 26, 2010, by the Financial Accounting Standards Board (FASB) on the topic of “Accounting for Financial Instruments and Revisions to the Accounting for Derivatives Instruments and Hedging Activities” can only marvel at the intellectual impossibility of the proposed new standards. The proposal, if approved, would expand Fair Value Accounting (FVA) to loans, debt securities, and most financial liabilities, including core deposits, far beyond its current application.

While most readers may be overwhelmed by the sheer size of the document and the effort required to respond to the 71 questions to which FASB would like responses, the real question is: Is FVA the proper accounting model for a financial intermediary that creates the majority of its income by collecting/paying interest on its assets and liabilities (e.g. investing rather than trading)?

I believe this proposal, if adopted, will be the end of fixed-rate loans, and the beginning of much trouble for banks, their customers, and their owners.

FASB keeps veering off course

With the release of this proposal, FASB has again demonstrated how out-of-touch it is with the real world. FASB continues to deviate from its own established Mission Statement and concepts.

When FASB was established over 30 years ago, one of the board’s main objectives was to enhance accrual accounting techniques to make financial statements more easily understandable to the average investor. Within this objective was also the concept of the cost versus the benefit of proposed accounting changes.

The May 26 proposal fails to meet either criterion. It also fails in that the proposed accounting changes would not reflect the true business model of a financial intermediary that creates a profit/loss statement based upon cashflows (as compared with trading). Much of the information that would come from the proposed changes is already available,  either in footnotes or FAS 107 disclosures. The implementation costs of the proposed changes would be astronomical relative to what little additional information, if any, might be available to investors. The fact that FASB needs responses to so many questions indicates how poorly the proposal had been thought through.

The fair-value proposal was approved by a vote of 3-2 by FASB’s Board on the premise that investors would benefit from improved information. To date, investor surveys seem to overwhelmingly discredit that assumption. The Office of the Comptroller of the Currency (OCC) has held outreach meetings with investors who are overwhelmingly against the proposed new accounting standards. (Read about a recent PriceWaterhouseCoopers investor study)

What fair-value will lead to

Should the fair-value proposal be implemented as proposed by FASB, the ramifications for the banking industry would be incredible.

First, the accounting changes would, in all likelihood, mean the end of fixed-rate lending.

Most banks would not want to be required to mark their loans to market if rates rise. The elimination of fixed-rate lending by financial intermediaries would have significant negative ramifications for many industries within the U.S.

Second, the implementation costs would be prohibitive for most financial institutions.

The software that is currently used for accrual accounting would require complete recoding. Banks of all sizes would need models to calculate the fair value of loans as it relates to each bank’s credit scoring system. Additionally, each bank would also need to conduct, at least annually, core deposit studies to justify the fair-value valuation of the core deposit base.

The cost of the FVA implementation would be enormous.

Third, there would be little comparability between different institutions’ financial statements.

Why? The models used to calculate the fair value of each financial institution’s assets and liabilities would differ in logic and scope. Each bank would have different risk ratings for loans and different models for calculation of core deposit values.

Last, and perhaps most important, fair-value results will often not be reflective of a financial institution’s actual cash-flow earnings.

It would be very possible for a financial institution with excellent cash flow earnings to be reporting large losses based upon the fair-value model. Simply stated, fair-value does not reflect the business model of a financial intermediary.

Bankers and investors must comment now

Financial institutions of all sizes could be severely damaged if the fair-value proposal is implemented. What is required to defeat this proposal is grassroots opposition from financial institutions, regulators, investors, and accounting firms. This proposal should be opposed with formal comment letters before Sep. 30, 2010. (See information after the conclusion for help.)

• Financial institutions
should oppose fair-value because it is not reflective of the business of a financial intermediary that holds assets and liabilities for cashflow earnings and not for trading. They should also oppose the proposal because of the implementation costs and the theoretical nature of the models and assumptions that would be necessary in order to attempt to comply.

• Regulators should oppose the fair-value proposal because it is not representative of a financial institution’s business model. The earnings and capital volatility created by fair-value could cause a loss of credibility in the banking system at a time when the image of the system is already severely tarnished.

• Investors
should oppose fair-value because of the prohibitive implementation costs and the fact that there is little additional information to be obtained that is not already available in public filings and footnotes to the financial statements.

• Accounting firms
that currently have financial institution clients should oppose the proposal because they know it will be harmful to their clients, will be difficult to implement,  and is not an accounting model that is reflective of a financial intermediary’s business.

It is not only the time to resist the fair-value proposal; it is also the time to question the effectiveness and credibility of FASB for proposing accounting standards. There needs to be a new approach that either holds FASB to its original reason for existence or creates an entirely different entity and process for establishing useful, meaningful, and practical accounting standards.

For now, this is the time for all interested parties to weigh-in against FASB and its irresponsible proposals. Please send your comments now—while there is still time to make a difference.

Editor’s Note:
While ABA is on record regarding and actively engaged in opposing, this article is not an official statement of ABA policy.

About the author

George Darling is CEO of Darling Consulting Group, Newburyport, Mass. Darling and the consultants of his asset-liability management firm write the "ALCO Beat" column. Darling’s professional experience includes: thirty years with his own company, two years as a senior executive with a $2 billion financial institution, two years with a Big Five Accounting firm, and ten years with IBM. He is a nationally-recognized resource for assisting financial institutions in the areas of interest rate risk management, liquidity management, and capital planning.


ALCO Beat articles featured exclusively on are written by the asset-liability management experts at Darling Consulting Group. Individual authors' credentials appear with their articles. DCG's consultants have served the banking industry for more than 30 years. You can read more about the firm's history here.

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